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Caution Tape

Buyer Beware: The Highest-Yielding REITs May Be Dividend Traps

[Updated: Aug 12, 2020] Sep 16, 2019 by Matt Frankel, CFP
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High dividends are great, but only if they’re sustainable and secure. You’ve probably heard the old saying "If something sounds too good to be true, it probably is." Well, this definitely applies to dividend investing.

Dividends that are attractive but unsustainable are often referred to as dividend yield traps or dividend traps. For example, if a stock pays a 12% dividend yield, but the company is paying out more than it makes, it could be a dividend trap.

Dividends that are attractive but unsustainable are often referred to as dividend yield traps or dividend traps.

When you’re looking at REITs, dividend traps can be tricky to spot, since these stocks are known for their high dividends.

The highest-yielding REITs and what you need to know

We’ll take a look at how to identify dividend traps in the next section. First, here’s a look at the highest-yielding equity REITs with market capitalizations of $500 million or more.

Company Name (Stock Symbol) Property Type Dividend Yield
Washington Prime (NYSE: WPG) Shopping centers 23.0%
Pennsylvania Real Estate Investment Trust (NYSE: PEI) Shopping malls 12.8%
Global Net Lease (NYSE: GNL) Various single-tenant 11.6%
American Finance Trust (NASDAQ: AFIN) Various single-tenant 10.6%
Sabra Health Care REIT (NASDAQ: SBRA) Healthcare (skilled nursing and senior housing) 9.4%

Data source: CNBC. Yields as of 5/30/19

There are some clear patterns to notice here.

The top four stocks on the list all have a great deal of retail exposure. The first two are all retail, while the two single-tenant REITs have lots of retail tenants. There is a great deal of chaos in the retail industry right now, with bankruptcies, store closures, and a general uncertainty about how the rise of e-commerce will ultimately affect the industry.

Skilled nursing is another industry with a lot of uncertainty, as well as many financial problems among facility operators.

Avoiding dividend traps

Of course, the five stocks in the list aren’t the only equity REITs with too-good-to-be-true dividend yields. Far from it. So here’s a quick list of ways you can avoid investing in dividend traps.

Check the payout ratio

A stock’s payout ratio is its per-share annual dividend as a percentage of its earnings. For REITs, the best method is to compare the dividend to the REIT’s funds from operations, or FFO.

For example, a REIT that pays $0.80 per year and earns $1.00 would have an 80% FFO payout ratio. High payout ratios are common with REITs: 70%–90% is normal. Anything above 100% could be a red flag.

Slowing (or negative) growth

It's important to not only take notice of a REIT’s current revenue or FFO, but also to check the recent trends. For example, if a REIT earns more than enough money to cover its dividend, but FFO has declined for the past two years, it could be a sign of trouble to come.

Debt levels

The average REIT has a debt-to-capitalization ratio of about 32% as of May 2019, and excessive debt could be a sign of trouble. Interest coverage and debt-to-EBITDA are two other good metrics to compare with peers in order to evaluate a REIT’s debt situation.

Troubled industry

The market often discounts stocks that operate in industries with significant headwinds.

For example, the senior housing industry is dealing with oversupply problems, and several facility operators are facing financial troubles of their own. Non-discretionary retailers are also facing difficulties as e-commerce continues to grow.

Be very cautious before investing in an industry that’s facing a lot of trouble or uncertainty.

Compare the yield with peers

One of the least technical, yet most reliable, ways to detect dividend traps is to compare a REIT's yield with that of its peers.

For example, if the average telecom stock pays 5%, one that pays 6% may not be too alarming. However, one that pays 11% is a different story. Using our REIT examples in the chart, notice that there are two companies that invest in single-tenant properties, both of which yield more than 10%. If you’re thinking about investing in one, consider that the average single-tenant REIT pays about 4%. That should make you think twice -- or at least take a closer look.

Proceed with caution

Not every high-yielding REIT is a dividend trap. If it doesn’t fail any of the tests above, it could be a perfectly safe above-average dividend yield. However, if a high-yield REIT raises even one of the red flags discussed, approach it with extreme caution.

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Matthew Frankel, CFP has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.